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Big Trouble Brewing.

I do not toss around the idea of a market crash lightly. If you’ve been following me long enough, you know that only in very rare instances do I issue a cautionary Alert (I’ve only issued four since my website launched in 2008), and I am generally not given to hyperbole.

Let’s be clear: I’m not issuing an Alert at this time. But I am concerned that a materially adverse disruption to the financial markets is increasingly likely in the near future.

Perhaps a definition will be helpful as we begin. A ‘market crash’ is an event where there are no bids to meet a wall of selling. The actual amount of the percentage decline is less important to note than the amount of chaos, or loss of control, that a given market experiences. Some like to say that a market downdraft requires a decline of 10%, or maybe even 15% or 20% (or more), in order to qualify as a ‘crash.’ For me, the key factor is not so much the amount of the decline, but the pace of the decline.

With perhaps a quadrillion US dollars of hyper-interconnected derivatives outstanding — that’s the notional value, but who really knows what the real number is? — an orderly market is essential for knowing whether or not the counterparty to one’s trade is solvent. During periods of intense price swings in the market, such things are simply not knowable, and spawn the fear and paralysis that really define a market crash.

The Next Market Crash

Like everybody, I have no idea when the next market crash will occur, but I do happen to hold the view that a market crash is on the way. In fact, my view is that the entire future from here onward will be marked by sharp plunges (both crashes and regular market declines), followed by periods of stability, if not apparent recovery.

What I track instead are imbalances and risks. Sort of like being a fire marshal who takes note of an outlet with fifteen things plugged into it, some with frayed cords, located near a pile of old cleaning rags. I can’t tell you for sure that a fire will result, only that the odds are elevated. A prudent person will take steps to remedy the situation or at least prepare for the possibility of a fire.

Here’s one view of the possible trigger for the next meltdown from Dr. Robert Shapiro, advisor to Presidents Clinton and Obama, and now the IMF, as offered on BBC Newsnight on October 5, 2011:

“If they cannot address this [the sovereign debt crisis in Europe] in a credible way, I believe within perhaps two to three weeks, we will have a meltdown in sovereign debt which will produce a meltdown across the European banking system.

We’re not just talking about a relatively small Belgian bank, we’re talking about the largest banks in the world. The largest banks in Germany, the largest banks in France that will spread to the UK in part through the sovereign debt problems in Ireland.

It will spread everywhere because the global financial system is so interconnected, all those banks are counterparties to every significant bank in the US and in Britain, and in Japan and around the world. This would be a crisis, in my view, more serious than the crisis in 2008.”

What he’s warning about here are two main things. The first is the risk of contagion, where problems in one area spread to another because everything is so intertwined. The second is that you can count on the rot spreading from the weaker periphery to the stronger core. Crisis always progresses from the outside in.

That dynamic has been playing out for months, and it should be obvious to the most casual of observers that the Greece situation has not been improved one iota by any of the steps yet taken.

The stakes could not be higher. Normally staid politicians are letting their guard down and saying previously unthinkable things. For example, this shocker recently came from the Polish finance minister:

Speaking to MEPs in Strasbourg on Wednesday morning (14 Sept) [the Polish finance minister] warned of the need to act rapidly to prevent grave danger for the EU. Making reference to a recent report entitled ‘Euro Break Up – The Consequences’ by Swiss financial giant UBS, he declared: “There is no doubt we are in danger. Europe is in danger”.

The paper by UBS, normally known for its highly sober analysis, warned that historically, monetary unions do not break up without civil waror some other form of authoritarian reaction. “The risk of civil disorder questions the rule of law, and as such basic issues such as property rights. Even those countries that avoid internal strife and divisions will likely have to use administrative controls to avoid extreme positions in their markets”, it said.

The Polish minister went on to warn of a doubling of unemployment within two years “even in the rich countries”.

He concluded his comments by recollecting a recent conversation he had with an old friend who is now head of a major bank: “We were talking about the crisis in eurozone. He told me ‘You know, after all these political shocks, economic shocks, it is very rare indeed that in the next 10 years we could avoid a war’. A war ladies and gentlemen. I am really thinking about obtaining a green card for my kids in the United States”.

I’m not sure whether the US will be a much better place to ride out the storm if the European banking system collapses, as it will be only a matter of time before the US is exposed as being just as financially and fiscally ruined as the EU.

Supporting this view is a rather famous Harvard economist (and the probable successor for Bernanke’s current position, according to some rumors):

Martin Feldstein says there’s a “nontrivial” chancethe U.S. economy will turn down again and calls the recovery “about as bad an expansion as I’ve ever seen.”

Another downturn here will further expose the fact that there are still towers of tottering debt that can only be serviced by an expansion, and a robust one at that. With this next revelation of systemic weakness, expect more debt defaults, institutional failures, and the same sort of banking weakness seen in Europe to occur in the US.

In short, there’s every chance here that an even worse repeat of 2008 could happen at any time. And in my estimation, the chance that this will come in the form of a market crash is too high to ignore.

Right now, with the rot creeping from the outside in, I see those chances as not only high, but rising.

From the Outside In

It can be very difficult to envision what an ‘outside in’ crisis looks and feels like. In order to get a better feel for the dynamic, we turn to Phoenix, Arizona for an excellent case study.

Once the darling of the housing boom, with endless desert building lots enabling the most egregious sort of bubble sprawl, Phoenix is now in the grips of a horrific housing crash. Like all big adjustments, it appears to those experiencing it to be in slow motion:

Phoenix-area real estate collapse echoed troubles

Oct 9, 2011

A look at metro Phoenix’s foreclosure crisis over the past five years shows an economic crash moving through time and space.

The collapse started in new-housing areas on the fringes and then swept inward, hitting more established areas as the unemployment rate climbed. Now, as the stock market struggles and speculation swirls about another recession, foreclosures are flaring in the Valley’s luxury-home neighborhoods.

That’s a perfect illustration of the ‘outside in’ dynamic. At the beginning of the bubble’s burst, it was almost certainly unthinkable to the inhabitants of the wealthier neighborhoods that they would get swept up in the cataclysm. But they did — first the weaker and more distant locales, then the middle-strength ones, and then the core.

The article continues:

A new Arizona Republic analysis, which maps out every home in default in the region over the past five years, is the first comprehensive look at the wave of foreclosures that has swept the Valleysince the market began its steep decline in 2007.

The analysis, based on data from Phoenix foreclosure-information service AZ Bidder, plots individual foreclosures and overall trends by year.

It shows how the Valley’s foreclosure crisis was more than one crisis. Foreclosures arose in waves, driven first by problematic mortgages, then by the job woes of the recession and now by lingering economic effects being felt in expensive neighborhoods.

It wasn’t just caused by housing weakness alone, but the way that housing weakness led to job weakness, and how they ended up preying together on confidence in the bubble and ultimately dragging down the local economy.

One more perfect passage from that article that illustrates our point:

As Phoenix’s foreclosure crisis crept inward from the fringesduring late 2008, it was being driven not just by subprime lending but also by the economy at large.

The state and the nation had fallen into a recession. Hundreds of thousands of jobs, many in the construction industry, were lost in Arizona.

As metro Phoenix’s unemployment rate climbed, so did foreclosures. The number of borrowers losing Phoenix-area houses to lenders hit a record in 2009.

Foreclosures began to affect communities closer in, where less speculation and new building had taken place. Chandler, Gilbert and Glendale, as well as central and north Phoenix, began to see foreclosures climb and home values fall.

Similarly, the European debt crisis began in the weakest locales first (Ireland and Greece), then infected the middle countries (Portugal, Italy, and Spain) and now threatens to overrun the core (Germany and France). A wave of sovereign defaults will sweep across the region, progressing from the outside in with a self-sustaining and self-reinforcing dynamic, unless somehow stopped.

That’s the important risk to focus on. And whether the crisis is a little one or one that ends in everyone’s worst fear — another war on the Continent — remains to be seen. But the probability of an approaching market calamity is non-trivial. So that brings us to the main insight we are trying to convey here: We need to be prepared for a major market clearing event that finally allows the rot to be cleared from the system.

Progressive Failure

The problem in Europe is very far from resolved at this point, the recent happy noises about Belgium nationalizing part of Dexia bank notwithstanding. As an aside on that matter, I found this to be quite interesting:

Belgium nationalizes part of Dexia bank for $5.4B

Oct 10, 2011

The Belgian state will buy the national subsidiary of embattled bank Dexia for euro4 billion ($5.4 billion) and provide tens of billions of euros in new guarantees as part of a wider bailout of the lender, the first victim of a new squeeze in European credit markets.

On top of the nationalization, the governments of Belgium, France and Luxembourg together will provide an additional euro90 billion ($121 billion) in funding guarantees for the bank for up to 10 years.

Belgium will provide 60.5 percent of these guarantees, 36.5 percent will come from France and the remaining 3 percent from Luxembourg.

This means Belgium is potentially on the hook for $78.6 billion in bailout funds for a single institution, which amounts to 17% of GDP (2010 figure). To put this into perspective for our US readers, that would be the equivalent of the USA guaranteeing $2.6 trillion…for a single bank. Anybody care to guess whether the amount that they decided to guarantee will be ultimately sufficient to cover the actual amount of the total potential losses? My guess is that over time the number will prove to be far, far below the final and true cost.

Even if the Dexia situation has been temporarily stabilized, Greece has not, and this is where the Europe story really begins. With Greek ten-year notes over 24%, two-year notes of 75%, and one-year notes over 150%, there is virtually no chance of anything happening other than a Greek default.

A writedown of Greek debt is inevitable here; the only question is, how much? Here’s the current view:

Europe Divided on Greek Writedowns That Juncker Says May Top 60%

Oct 11, 2011

European Central Bank President Jean-Claude Trichet said Europe’s debt crisis now threatens the region’s financial system as officials race to put together a new plan to end the turmoil.

“The crisis has reached a systemic dimension,” Trichet told lawmakers in Brussels today in his capacity as head of the European Systemic Risk Board. “Sovereign stress has moved from smaller economies to some of the larger countries. The crisis is systemic and must be tackled decisively.”

European leaders are trying to shore up the region’s banks as they debate how best to manage the fallout from any Greek default. Governments yesterday pushed back a summit amid opposition to Germany’s drive for deeper-than-planned Greek bond writedowns that Luxembourg’s Jean-Claude Juncker says may exceed 60 percent.

“Time is always of the essence when you have to be in a mode of crisis management,” said Trichet.

A ‘writedown’ is just another of many more pleasant-sounding terms that are being used instead of ‘default,’ which is precisely what Greece will soon be doing.

With the triggering of a default, the fear of contagion will spread, because, frankly, nobody really knows where the time bombs are located in the credit default swap (CDS derivative) markets. Sure, we can know roughly who is holding what, but each of these holdings is then linked to the primary institutions’ own credit ratings, which themselves have vast piles of CDS paper attached to them. In other words, everything is so interconnected that it’s nearly impossible for anyone, even the owners of these derivatives, to conduct an accurate risk-assessment or predict how they’re going to behave during a market dislocation.

These in turn are held by other institutions and funds, which are heavily leveraged and exposed to the very same market forces that will assure that the exact opposite of hedging will erupt during the hairiest part of the coming rout.

For perspective, Greece has nearly 330 billion euros ($445 billion) of debt outstanding, on top of which CDS paper has been layered. That is, if Greek debt gets a 60% haircut, the basement-level losses we can expect as a result are $270 billion, but the CDS paper will certainly amplify that number much higher for some unlucky institutions.

For even more perspective, consider that Spain and Italy have nearly $3.4 trillion in debt, making their combined predicament worth about 7.5 Greek dramas.

If you think the big banks represent the smart money, I would remind you that when the subprime CDS disaster finally blew up, it was the big banks (and AIG) that were holding the bag — supposedly the smartest of the smart money. I somehow doubt they are going to be any smarter this time.

The contagion fear here is that several mega banks (and/or funds) will fail as a result of these cross-correlated and therefore unhedged bets. When the European Banking Authority ran their stress tests a while back, several very large banks in Spain and France barely passed, and that was without booking any losses on any of their outstanding loans to Greece, Ireland, or Portugal. If one tips over, so will the rest, because they all owe each other.

To simplify, here’s a picture of the world banking system as it currently stands:

Another form of contagion will come with the thought that if one major Western economy can default, others can, too. A precedent will have been set, and other over-indebted economies will suffer higher interest rates on their borrowing as a result. The thing about higher interest rates is that once they are past a certain level, they become self-fulfilling prophecies, virtually assuring that default is a mathematical inevitability (see Greece, above). Over the long haul, interest rates over the long haul cannot be higher than the nominal rate of GDP growth, generally speaking. In today’s low-growth environment, that is a low bar, indeed; perhaps just 2%-3%.

A final concern for European banks (in particular) concerns bank runs, in which institutional and retail depositors decide to flee a given bank, causing it to topple over, as the first domino in a long line.

The bottom line here is that the European situation is quite far from resolved, and as we’ve been saying all along, it really can’t until large losses are taken by someone. For now, the banks are trying desperately to convince the world that the losses should be shared by everyone through the miracle of inflation (with central banks printing money, a.k.a. “quantitative easing” or QE, to buy the bad debts off the banks) while the people of various countries are increasingly protesting this regrettable practice of socializing banks’ losses, yet allowing privatized profits.

Expect Volatility

The key point to understand about our economy is that it is anything but straightforward and linear. It is a complex system, meaning that it has two characteristics of which we should be aware: It requires energy to maintain and/or increase its complexity, and it is unpredictable.

One typical feature of complex systems is that they tend to jump rather abruptly from one state to the next. Where they can exist in some sort of seeming equilibrium for quite a while, a sufficient exogenous shock (or a change in conditions, such as becoming energy-starved) can often cause them to transition rather suddenly to the next point of ‘equilibrium’.

Said more simply, systems often have tipping points, where they no longer react to insults proportionally, but chaotically and sometimes violently. Phoenix, Arizona was coasting along just fine until experiencing a tipping point in its housing market that involved both the job market and the broader economy, dragging both down on the way to finding a new and much lower equilibrium point.

Focus on Positioning Yourself Prudently

What we have here is an ideal set of conditions for a tipping point to arise in our financial system. When such a tipping point occurs, you should expect wild volatility in the markets and be prepared for things to be moving far too quickly to react to with any sort of precision or grace.

That’s why it’s best to be pre-positioned in your financial, physical, and emotional preparations, so that when the next bout of extreme volatility exerts itself, little to no immediate action is needed on your part during the tumult.

Ride out the chaos in safety and confidence. Be a support to those less prepared within your family and community. And take advantage of the luxury few will have to plan your next steps carefully, once the corrective forces clear much of the current uncertainty out of the markets. Doing so will set you up better than most to prosper in the aftermath.

About the Author

Executive summary: Father of three young children; author; obsessive financial observer; trained as a scientist; experienced in business; has made profound changes in his lifestyle because of what he sees coming.

First of all, I am not an economist. I am trained as a scientist, having completed both a PhD and a post-doctoral program at Duke University, where I specialized in neurotoxicology. I tell you this because my extensive training as a scientist informs and guides how I think. I gather data, I develop hypotheses, and I continually seek to accept or reject my hypotheses based on the evidence at hand. I let the data tell me the story.

It is also important for you to know that I entered the profession of science with the intention of teaching at the college level. I love teaching, and I especially enjoy the challenge of explaining difficult or complicated subjects to people with limited or no background in those subjects. Over the years I’ve gotten pretty good at it.

Once I figured out that most of the (so-called) better colleges place “effective teacher” pretty much near the bottom of their list of characteristics that factor into tenure review, I switched gears, obtained an MBA from Cornell (in Finance), and spent the next ten years working my way through positions in both corporate finance and strategic consulting. From these experiences I gather my comfort with numbers and finance.